Understanding the Stock Market

For something that we hear about quite a bit in our lives, that can affect us significantly, it’s surprising that many people do not really understand the stock market. It’s not hard in principle, but there are some common misconceptions and misunderstandings.

What Is it?

First, what is a stock? It is sometimes also called a share, and that is more descriptive. Owning a share is the same as owning a part (a very small part usually) of the company whose name is on the share. You don’t get a whole lot with it, for instance you can’t go and park in the Chairman’s parking space, but you have bought yourself an interest in the company. Occasionally, companies give share owners, or shareholders as they are termed, the benefit of a perk, such as a discount on the company’s products, but you shouldn’t expect it.

What you might expect and often get is a “dividend”, frequently issued on a quarterly basis, and this is a payout of some of the company’s profits for the last trading period. You’re more likely to get a dividend from a large company than a small company as these frequently want to plough back any profits into expanding in their marketplace, whether through research or through buying more equipment.

Shareholders get invited to an Annual General Meeting when the company’s leaders talk about their past history and future hopes. As a shareholder, this is an opportunity for you to express yourself and vote on any decisions that come up, but the general running of the company from day to day is done by the company’s officers.

As you don’t get much say, and may not even get any income from being a shareholder, what is the attraction? Why do so many people do it? The answer is that you are expecting the value of your shares to increase, and thereby increase your fortune when you eventually sell them. On average, shares have increased in value over the years much faster than most other regular money investments such as savings accounts.

If you’ve been aware of the markets over the past few years, you will know that shares do not increase in value all the time, so the words “on average” are the important ones in that last sentence. In fact it is possible to lose a lot of money by buying and selling shares.

Economists will tell you that the variation in price comes from supply and demand. If suddenly everyone wants some shares in a particular company, the demand has increased and the price will go up – in other words people who already own the shares and will consider selling want to get more for them because of the high demand. But say everyone was down on a particular company, then the share owners might feel that they could hardly give them away, and be prepared to sell for a lower price.

The usual state of affairs is somewhere between these two extremes, so the price bobs up and down in response to particular people or companies looking to buy or sell at the time. Because it comes down to the individual trades, you will find the prices constantly changing even when they are relatively stable in the longer-term. We’ll talk later about what people do to try and pick shares that will be winners for them.

That describes what a stock or share is. The other part of “stock market” is market. You probably know what a “market” is. Your shopping may well include a trip to the supermarket, and you may also be familiar with street markets, where vendors set up stalls selling different goods. The market is simply a place where people meet to buy and sell, and so it is with a stock market, at least in its original form. People meet to buy and sell stocks and shares, and sometimes the floor of the stock exchange has been portrayed as a hectic place, with much shouting and waving of arms.

Two points about stock markets. First, you can’t walk in off the street and start buying and selling shares. That’s only permitted by people who are authorized to do it, and that’s why any transactions you do have to go through a stockbroker or dealer. The fact is that much of the trading goes on word-of-mouth, as there is not time to keep passing around rolls of banknotes. Therefore they have to know exactly who they’re dealing with and that they can trust them to stand by every deal that’s agreed.

Secondly, technology is increasingly changing the traditional share dealer’s job, and a growing amount of it is accomplished with computers. In fact, the US NASDAQ stock exchange started life in the 1970s as a purely electronic bulletin board without any premises at all. By the way, NASDAQ is the proper name for this market now, but it started out being called the National Association of Securities Dealers Automated Quotations. You can appreciate why they adopted the abbreviation as the full name. These days, a great deal of stock trading is done via computers online, but you will still find professional traders in the stock exchanges.

There are many different stock exchanges around the world, and many companies are only traded on particular exchanges, usually in the country where they operate. The London Stock Exchange is the main market for British companies, and the United States has several markets, including the NASDAQ which has already been mentioned and the New York Stock Exchange. Most countries have their own markets, and large companies are sometimes listed on several markets, particularly if they have big operations in different countries. However, modern technology allows for all the share prices to be synchronized around the world.

Why Is It?

So that describes what stock markets are now. The first stock markets started several centuries ago. It would be very difficult and expensive for you to own part of a company before that, as all companies were privately held and owned by rich investors. Of course this is still happens in the present day, and some large companies have never even been available for the general public to buy.

No companies need to be listed on a stock exchange. It is a choice that the owners of a company make if they have a reason to raise more money than they have already available. They may even do it in order to get “some of their money out”, to realize some cash for their share of ownership that they can then use for other things. A private company may choose to obtain a loan, going into debt, rather than sell shares to the public. Private companies that you may know include Alliance Boots, which is owned by private investors; John Lewis, which is owned by the employees; and JCB, which is still family owned. Note that sometimes financial gurus may develop a special offer or way for the public to get an economic interest in a private company, but it is not the same as buying regular shares. You cannot buy regular shares in these companies on the stock exchange.

The IPO

When the owners of a company make a decision to “go public” and have their shares listed on the stock market, they usually hire financial advisers to prepare the Initial Public Offering, or IPO. The advisers take care of all the paperwork and suggest a price and number of shares to offer. You have probably heard of some people making fortunes by investing in IPOs and selling the shares later after they have risen in value. This doesn’t happen all the time, but has been the case enough times that it has become trading folklore.

It’s probably more likely than not that the shares offered on an IPO will increase in value. The financial advisers want to avoid the situation that the shares are not sold, so they would tend to set the price a little lower than otherwise to make sure they are all bought up. They will also try to deal with major corporate investors, getting assurances from pension funds and the like that the shares will be bought by them. But in the end, it’s the stock market that decides the price, and there have been some IPO flops. Anyone buy Facebook?